Capital Structure

 A company should seek to minimize its weighted average cost of capital.

 So how can a company adjust is financing structure in such a way that its
WACC is minimized?
o There are different views about the answer to this question. One is the
so-called 'traditional' view. Another is a view proposed by Modigliani
and Miller.
o Both views agree that:
 The cost of equity is higher than the cost of debt.
 As the level of gearing increases, the larger proportion of debt
in the capital structure means that there is a larger proportion
of lower-cost finance.
 However, as the level of gearing rises, the cost of equity also
rises, to compensate shareholders for the higher risk.
 As gearing increases, the higher proportion of low-cost debt but
the rising cost of equity pull the WACC in opposite directions.
The Traditional View
 The traditional view concludes that there is an optimal capital mix of equity
and debt at which the weighted average cost of capital is minimized.

 Under the traditional theory of cost of capital, the weighted average cost of
capital declines initially as gearing increases, but then rises as gearing
increases further. The optimal capital structure is at the gearing level where
WACC is lowest.

Modigliani and Miller View

 However, the alternative view of Modigliani and Miller (assuming no tax) is
that the firm's overall weighted average cost of capital is not influenced by
changes in its capital structure.
 Modigliani and Miller stated that, in the absence of tax relief on debt
interest, a company's capital structure would have no impact upon its WACC.
WACC would be the same regardless of the company's capital structure.
 Modigliani and Miller (MM) proposed that the total market value of a
company, in the absence of tax relief on debt interest, will be determined
only by two factors:
o The total earnings of the company
o The level of operating (business) risk attached to those earnings.

 Modigliani and Miller made various assumptions in arriving at this

conclusion, including:
o A perfect capital market exists, in which investors have the same
information, upon which they act rationally, to arrive at the same
expectations about future earnings and risks.
o There are no tax or transaction costs.
o Debt is risk-free and freely available at the same cost to investors and
companies alike.
 Modigliani and Miller later modified their theory to admit that tax relief on
interest payments does lower the weighted average cost of capital. The
savings arising from tax relief on debt interest are the tax shield.
o They argued that the weighted average cost of capital continues to fall,
up to gearing of 100%.
o This suggests that companies should have a capital structure made up
entirely of debt. This does not happen in practice due to the existence
of other market imperfections which undermine the tax advantages of
debt finance.
o Market imperfections
 Bankruptcy costs
 Agency costs
 Tax exhaustion
Pecking order theory
 This theory is based on the view that companies will not seek to minimize
their WACC. Instead they will seek additional finance in an order of
preference, or 'pecking order'.
 Pecking order theory states that firms will prefer retained earnings to any
other source of finance, and then will choose debt, and last of all equity.
The order of preference will be:
o Retained earnings
o Straight debt (bank loans or bonds)
o Convertible debt
o Preference shares
o Issue new equity shares
Impact of cost of capital on investments
 The market value of a company depends on its cost of capital.
 The lower a company's WACC, the higher will be the net present value of its
future cash flows and therefore the higher will be its market value.
 The weighted average cost of capital can be used in investment appraisal if:
a) The project being appraised is small relative to the company.
b) The existing capital structure will be maintained (same financial risk).
c) The project has the same business risk as the company.

 CAPM can also be used to calculate a project-specific cost of capital.

o The CAPM produces a required return based on the expected return
of the market E(rm), the risk-free interest rate (Rf ) and the variability
of project returns relative to the market returns ().
o Limitations of using CAPM in investment decisions
 It is hard to estimate returns on projects under different
economic environments
 The CAPM is really just a single period model
 It may be hard to determine the risk-free rate of return
 betas calculated using complicated statistical techniques often
overestimate high betas, and underestimate low betas,
particularly for small companies.
Example: CAPM and Investment Appraisal
Panda is all-equity financed. It wishes to invest in a project with an estimated beta
of 1.5. The project has significantly different business risk characteristics from
Panda's current operations. The project requires an outlay of GHS10,000 and will
generate expected returns of GHS12,000. The market rate of return is 12% and the
risk-free rate of return is 6%.
Required Estimate the minimum return that Panda will require from the project
and assess whether the project is worthwhile, based on the figures you are given.

Required return = Rf +  (E (rm) – Rf )

= 6 + 1.5(12 – 6) = 15%

Expected return = 12,000 – 10,000 10,000 = 20%

10,000
Thus the project is worthwhile, as expected return exceeds required return.

CAPM and MM combined – geared betas

 When an investment has differing business and finance risks from the
existing business, geared betas may be used to obtain an appropriate cost of
capital and required rate of return for an investment.
 Geared betas are calculated by:
o Ungearing industry betas
o Converting ungeared betas back into a geared beta that reflects the
company's own gearing ratio
 The  value of a geared company will be higher than the  value of a company
identical in every respect except that it is all-equity financed.
o This is because of the extra financial risk.
  The mathematical relationship between the 'ungeared' (or asset) and
'geared' betas is as follows.

Where a is the asset beta or ungeared beta

e is the equity beta or geared beta
d is the beta factor of debt in the geared company
Vd is the market value of the debt capital in the geared company
Ve is the market value of the equity capital in the geared company
T is the rate of corporate tax

 Debt is often assumed to be risk-free and its beta (d) is then taken as
zero, in which case the formula above reduces to the following form.

Example: Gearing and Ungearing betas

KAF is a manufacturer of consumer electronics based in Accra, Ghana. KAF
finances its investments with a combination of equity and debt. Its equity capital
comprises 10 million shares which are currently trading on the stock exchange at
GH¢2.55 per share. Its equity beta is 2.1 currently. The return on the risk-free
security is 12.5% while the equity risk premium is 10%.
Included in KAF’s debt stock are irredeemable bonds that have a total face value
of GH¢10 million while their total market value is GH¢12 million. The annual
coupon of the irredeemable bonds is 18% but is paid semiannually.
The directors of the company are considering two new investment opportunities,
which are described below:
Project 1
This is an expansion project in the consumer electronics manufacturing industry.
It involves the setting up of a new factory in the northern part of Ghana. KAF
would finance it with existing capital.

Project 2
This involves the installation of a new factory to manufacture furniture for export
to foreign markets. Although this investment is a completely new line of business,
KAF plans to finance it with existing capital. The average equity beta for the
furniture manufacturing industry is 1.52 and average industry capital structure is
60% equity and 40% debt.

It is expected that KAF’s tax rate will remain at 22%.

Required:
i) Compute the cost of capital that should be used as discount rate for
appraising Project 1.
(5 marks)
ii) Compute the cost of capital that should be used as discount rate for
appraising Project 2. (5 marks)